World Economic Outlook and Implications For Korea Anne O. Krueger

1. World Economic Outlook and Implications For Korea Anne O. Krueger Stanford University and Johns Hopkins University To be presented at KSP Conference in Seoul, October 23, 2012.

2. OUTLINE • Introduction • The global economy performed very well in the last half of the twentieth century. • Shifting structure of the global economy as the 21st century begins • Cyclical factors dominate in the first decade • European situation • Inevitabilities going forward • Short-term outlook • Longer-term outlook • Implications for Korean Economic Policy • Conclusions 1

3. Introduction • The half-century after the Second World War was exceptionally successful for the world economy. World economic growth remained strong throughout. • Until the past decade, however, the underlying structure of the global economy and the determinants of growth changed only slowly. Over time, those changes cumulated so that by 2000 the global economy had changed significantly. • Many lessons were learned, which is partly why economic performance improved. • But the difficulties of the last decade have raised many questions. There is much more uncertainty about the future than at earlier times. 2

4. The l950-2000 period was unique in world economic history. • Not only was there rapid growth in industrial countries, it was more rapid than ever before. Until the 1990s, the world economy seemed characterized by 3 groups of countries: industrial, “underdeveloped” and centrally planned economies. • World economic growth accelerated during the half century. Trade was an engine of growth. Successive rounds of multilateral tariff negotiations under the GATT and then the WTO led to greatly reduced trade barriers among developed countries. Lower trade barriers (and falling transport costs) led to increased trade volumes, which led to faster growth, • Private capital flows had dried up after the experience of the 1930s and the early years witnessed mostly official capital flows. It was only in the 1990s that private capital flows mushroomed. 3

5. The 1950-2000 period (continued) • As the half-century progressed, more and more “underdeveloped countries” learned how to adapt their policies and grew rapidly. Until the 1970s, they benefited greatly from the tariff reductions of the industrial countries, but did little to change their own trade barriers. Korea, Taiwan, Hong Kong and Singapore, the “Asian tigers”, led the way in changing trade (and other) policies and began growing rapidly. By the 1990s, many other countries (most importantly China and India) were growing rapidly. • The era was certainly one of “globalization” as lowering of trade barriers and integration of the world economy was a key contributor to good performance. • Although there were crises (oil price increases in 1973 and 1979, developing countries’ debt crises 1982-1988, Mexican crisis 1994, Russian, Asian, and Brazilian in late l990s to name a few), none significantly affected the entire world economy. Many parts of the world kept growing during each crisis period. 4

6. Shifting Structure of theWorld Economy • Most trends started during the half century but were not yet quantitatively large enough to change global responses. But by 2000 that was changing. • The United States had emerged as the dominant economy after the Second World War. Its share of world GDP and world trade fell almost continuously throughout the fifty years as other countries grew rapidly. It accounted for over 40 percent of world GDP after the Second World War, and less than a quarter by 2000. • The share of developing countries in world GDP and trade was low and falling in the l950s and l960s. Recovery of lost share began in the 1970s, but it was not until the 1990s that the share of the developing countries in world trade and world GDP began rising rapidly. 5

7. Shifting Structure of World Economy (continued) • Of course, the collapse of the U.S.S.R. also led to a structural shift as trade and capital flows between the countries whose economies had been centrally planned and the rest of the world rose. • By 2000, tariffs among industrial countries on manufactures were very low, but the momentum for multilateral tariff (and other trade barriers) reductions had diminished. More and more preferential trade agreements (PTAs) were formed. As of 2000, the most important was the European Union (EU), which was a customs union that was established in the context of multilateral trade integration. 17 countries in the EU entered into a common currency area – the eurozone – at the end of the decade. • Private capital flows resumed rapidly after the Asian crisis and dwarfed official capital flows for all but the poorest countries. 6

8. The First Decade of theSecond Millenium • Despite a downturn in 2000-2001 as the “tech” bubble burst and after 9/11, the first half of the decade witnessed very rapid growth of the global economy. It was the first time period in which all regions of the world shared growth. Moreover, growth in the “emerging markets” accelerated. China, whose growth had been rapid in the 1990s, was now large enough to be a major player, and Indian economic growth was accelerating. • Underlying that growth, however, were “global imbalances”. The current account deficit of the United States, and the current account surpluses of China and – after 2005 – the oil exporters, led to very low real interest rates and excesses in financial markets. Low real interest rates especially encouraged construction and real estate investments. • When the construction boom lost momentum, the financial crisis began. An overhang of new, especially residential, construction and falling housing prices meant that the recovery would be slow as the housing overhang was absorbed. The resulting loss of wealth and unemployment led to a sharp decline in world real GDP. Only in 2009 did recovery begin, and it was weak. 7

9. The European Difficulties • The crisis started in the United States. Some countries were harder hit than others, but most went into recession. A few, such as Canada and Australia, were largely unaffected, but emerging markets experienced sharp declines in exports at the outset of the crisis. • As the weak recovery from the financial crisis was getting under way, however, difficulties arose within the European Union. The first major difficulties were in Greece, but Ireland and Portugal soon followed, and as of early October 2012 Spain and Italy were experiencing continuing problems. • The Greek crisis was triggered by very large sovereign debt, much of which was held by the private banks of EU countries, and the crisis rapidly spilled over and became a sovereign debt and banking crisis. 8

10. European Difficulties (continued) • Concerns about the sustainability of the euro and the outlook for growth within the euroarea have overhung the world economy. Reduced demand from EU countries for exports has affected many, including China, whose growth rate has fallen. Prospects for growth and the stability of European financial institutions have dampened the outlook for other industrial countries and emerging markets. • Eurozone responses to the difficulties of the southern eurozone countries have been slow, partly because of difficulties in reaching agreement among the 17 sovereign nations, partly because of the different concerns of the north and south, but also because of the politically painful measures that need to be taken. • That slowness, in turn, has aggravated anxieties in other countries. The financial and trade linkages with the rest of the world are high and the current recession and weak outlook affects all other regions. 9

11. Inevitabilities Going Forward • Even if the eurozone crisis had not happened, fiscal sustainability would need to be restored in many countries. Large expenditures to offset the recession led to huge runups in debt and in many countries fiscal consolidation is called for. • Moreover, the industrial countries and some others (especially China and South Korea) are confronted with major challenges as their rapidly shifting demographics will require significant fiscal adjustments to prevent sovereign debt difficulties. It is estimated, for example, that in many countries the labor force will begin falling within the next decade while the fraction of elderly will rise. Because expenditures for health care and social insurance are greater for the elderly than for the working population, the number of workers per old person will fall sharply. Either expenditures will have to be cut, or tax revenues increased, or some combination of the two. Either way, more rapid growth will make the transition easier. 10

12. Inevitabilities Going Forward (continued) • While a few countries have already successfully taken measures to avert major problems (and starting sooner makes adjustment much easier), many have not. And the fiscal challenge of restoring sustainability after the increases in debt because of the financial crisis and meeting the challenges of aging populations will confront most countries. How countries meet these challenges will be an important determinant of future growth. • For the United States, there is a pressing, virtually immediate, challenge: the fiscal cliff. It is estimated that the U.S. government’s fiscal balance will shift by 5 percentage points of GDP between 2012 and 2013 unless action is taken. To date, there is an impasse between parties as to how to do this. • If the issue is satisfactorily addressed (by postponing the tax increases and delaying the impact of some other measures), the outlook for the U.S. economy in the short term seems good. If, however, there is no change in current legislation, the negative effect on US GDP could be substantial. Whether Congress will act in time is unknown. 11

13. Short-term Outlook • For the short-term, there are several uncertainties. Chief among them are: the fiscal cliff, the decisions made in the euro area, and the short-term evolution of some key emerging markets. • The U.S. fiscal cliff is the most proximate. If nothing is done by the beginning of the new Congress in January, there are serious risks that the U.S. economy, whose short-term outlook is otherwise the most promising, will lose momentum and even fall into another recession. It is clear that no action will be taken until after the election. • For purposes of looking ahead, I shall concentrate on the case where the U.S. government somehow buffers the impact of the fiscal cliff. In that case, the outlook for the American economy is reasonably bright: construction seems to have bottomed out and may be picking up; the employment numbers look reasonably good. These, and other indicators, would suggest that the U.S. economy can expand at 2-3 percent in 2013 even if the rest of the world fares poorly. 12

14. Short-term Outlook (continued) • The second major uncertainty focuses on the euro area. Here, major questions arise as to how the economies of Greece, Portugal, Spain and Italy will fare (Ireland seems to be doing reasonably well). Questions arise as to whether the governments, especially that of Greece, will carry out their commitments under the IMF programs they are in. If not, the lack of funding for Greece would trigger an immediate crisis. Even if the programs are deemed to be sufficiently on track, some raise questions about their political sustainability. • Spain is sufficiently large so that there are questions about its banking system and fiscal position whether it seeks an IMF-EU-ECB program or not. • If those in programs cannot keep them on track, or if Spain or Italy does request IMF support, there is tremendous uncertainty as to how markets would react. Clearly, until these questions are resolved, economic activity in the Euro area will be dampened, and even with resolution, much would depend on the manner in which it takes place. 13

15. Short-Term Outlook (continued) • The short-term outlook for Europe is at best one for very slow growth. Japan, too, for different reasons does not appear to have strong prospects. • That leaves the large emerging markets, especially the BRICs (Brazil, Russia, India and China), whose combined growth contributed importantly to the recovery in 2009 and 2010. It is clear that the emerging markets have not “decoupled” from the industrial countries, but also that internal demand is more of a determinant of their growth than in the past. In the cases of India and Brazil, the short-term outlook is for slower growth, and even for China, observers are questioning how deep the downturn will be. • The U.S. (if there is sufficient reduction of the fiscal cliff), along with a few other smaller industrial countries (Nordics, Australia, Canada, perhaps the U.K., some Eastern Europeans), are likely to be the higher-growth countries over the short-term. But with the eurozone countries faring poorly, the Japanese economy sluggish, and slower growth in the BRICs and probably other emerging markets, the short-term outlook for the global economy is, at best, for slow growth over the next several years. • If prospects for the eurozone become clearer and more promising, the outlook for the world economy will be considerably brighter. 14

16. Longer-Term Outlook • As already seen, even if the short-term issues are satisfactorily resolved, governments will be confronted with the necessity for fiscal consolidation, both because debt levels have become uncomfortably high and because of looming demographics. • The longer-term challenge is to address the fiscal (and related) issues and simultaneously take measures to assure satisfactory growth rates. Fiscal problems themselves will be more readily addressed with more rapid growth. But a slowdown (and even decline) in labor force growth will by itself slow the growth rate. • For the industrial countries, measures to accelerate growth differ depending on their current policies and prospects. In all of them, finding policies that enable more rapid growth of labor productivity will be a crucial ingredient. So, too, will the further integration of the international economy. 15

17. Longer-Term Outlook (continued) • The growth of world trade has been an “engine of growth” throughout the past half century. Much has been accomplished, but there could be further gains. The Doha Round of trade negotiations seems dormant just at a time when successful conclusion could itself contribute to growth and also enable WTO members to address additional issues in services trade and in agriculture. • The international community could make a significant contribution to longer-term growth prospects by spurring the WTO forward with regard to remaining trade barriers. As many have pointed out, the evolution of world trade has led to pressing needs for a stronger WTO. In light of the urgent need to take measures to accelerate sustainable growth where possible, failing to take advantage of opportunities for further trade liberalization would be inexcusable. 16

18. Long –Term Outlook (continued) • Although actions have been taken to reduce the incentives for risk-taking on the part of financial institutions, there remain issues regarding institutions that are “too big to fail” and international coordination of regulatory frameworks. Even potentially more dangerous, no effective action has yet been taken to strengthen the capabilities of the international community, presumably through the International Monetary Fund, to avoid future global imbalances of the sort that contributed to the financial crisis of the past decade. It is to be hoped that the issue will not arise in the near future, and that measures can be taken before imbalances reemerge as a major issue. 17

19. Longer-term Outlook (continued) • For all the countries facing demographic transition, shifting the composition of production to more capital and skilled-labor intensive methods, increasing the human capital of the labor force (including technical skills as well as education), providing incentives for increased labor force participation (especially for women), and removing distortions in the economy will be vital. Such processes would entail appropriate provision for incentives for innovation. • As industrial countries move to make their economies more efficient and more flexible, growth rates can be enhanced; at the same time, increased opportunities will open up for those low-income countries that have not yet been able to achieve rapid growth. They can use their abundant labor to advantage, offsetting part of the loss in numbers in industrial countries. In so doing, the market for goods made in industrial countries would increase. 18 1

20. Implications for Korean Economic Policy • South Korea’s economic success is widely recognized throughout the world, as the country has transitioned from one of the poorest in the world to an industrial country. South Korean policy makers have generally been adept at recognizing bottlenecks to growth and taking measures to avoid them. • As the South Korean economy has grown and become more complex, the importance of reliance on policies that provide incentives for desired outcomes has increased, and will continue to do so. • In South Korea’s case, the demographic challenge is arising quickly. Appropriate measures to address it will include increasing labor force participation, upgrading human capital, and continued attention to removal of distortions, particularly in the labor market. • South Korea passed through a stage in which adaptation of methods already developed in other countries provided a strong spur to growth. Reliance on human talent and skills is already important and will become increasingly so. 19

21. Implications for South Korean Economic Policy (continued) • Increasing labor force participation, in Korea’s case, will probably entail at least two thrusts: increasing women’s labor force participation and raising the age of retirement. Average retirement age for workers in Korean firms was only 57 in 2008, well below that in most OECD countries. • Upgrading human capital will also be important. South Korea already has one of the best track records in the world for primary and secondary educational enrolments and achievements and spending on education is high. The quality of tertiary education is good at the top universities, but somewhat uneven. Focus on improving quality in tertiary institutions will be crucial in enabling increases in productivity and in spurring innovation. • More generally, like most other OECD countries, Korean policy makers will need to examine existing regulations and incentives governing economic activity. As recently as 2008, Korea was ranked 126th in the world (out of l86 countries) in the “East of Starting a Business” by the World Bank. Much has been improved since then, and the 2011 ranking was 24th. Policies to strengthen competition in services appear to be particularly important as a candidate for revision. 20

22. Conclusion • South Korea’s economic performance since the 1950s has been one of the best in the world. That outcome came about because of the opportunities catch-up provided, a healthy world economy, and good economic policy making in South Korea. Recently, the economy has been moving further up the “value-added chain”, and a higher proportion of growth will need to come from the skills and quality of the labor force. • There are still some opportunities for catch up but a higher proportion of growth must be reliant on the upgrading of skills and innovation both because the catch-up opportunities are smaller and because of the impending demographic transition. 21

23. Conclusion (continued) • Policies will necessarily be focused largely on aspects of the quality of the labor force. These will include increasing labor force participation, skill upgrading, and measures to increase labor force flexibility. Of course, increasing the flexibility of the economy in general is important, but South Korea’s vital asset now and in the years ahead is and will be the skills and flexibility of its labor force. • Continued participation in the international economy will also be central to Korea’s interests, as it has been in the past. The challenge of the demographic transition will best be met if “old”, unskilled labor using industries are transitioned out, while new, human capital and physical capital using industries gradually emerge. Of course, this should come about through market forces, and cannot be done by government fiat. Government’s role will continue to be to provide incentives and competition so that firms’ decisions are consistent with the overall needs of the economy. Given past performance, I am confident that the Korean economy will continue to be a stellar performer. 22